As the population of America ages, and as investors increasingly recognize the volatility and risk inherent in financial markets generally, the investment objectives and concerns of Americans are changing. For example, many investors generally desire diversified investments that provide a safe, steady income stream. Such investors also generally desire liquidity, so that their investment interests can easily be sold or rearranged. Additionally, many investors generally do not want to actively manage their investments.
Mature investors also may have numerous concerns related to inheritance. For example, many mature investors would like their investments to be divisible, so that they may be easily divided among heirs. Additionally, these investors may want their estates to be able to sell part of their investment holdings to pay estate taxes or for other uses.
Investment real estate has difficulties meeting many of these desires. Generally, small to mid-sized real estate holdings require active management to generate a steady current income and favorable long-term returns. Additionally, most real estate investors do not possess enough capital to acquire a sufficient number of properties to effectively diversify. Furthermore, if an investor divides the title to a small real estate holding such as a store or a single building for the benefit of his or her heirs, the collective pieces generally have less value than the whole and may be difficult, expensive and time-consuming to sell. Many of the foregoing concerns affect investors of all age groups.
Despite the foregoing difficulties, however, a large amount of money is currently invested in real estate that is either held for investment or used in a trade or business (“Like Kind Property”). This is because Like Kind Property can provide a wide range of benefits, including a favorable current income stream, the opportunity for capital preservation and appreciation, a hedge against inflation, possible tax benefits and a low correlation with other common investment vehicles such as stocks, bonds and mutual funds.
A sizable fraction of Like Kind Property holdings are owned by small to mid-sized real estate investors (e.g., those having holdings between $250,000 and $20 million). These small to mid-sized real estate owners may decide to sell their Like Kind Property for any number of reasons, including the desire to rebalance their investment portfolios, reduce day-to-day management burdens, diversify their investments, and create tax and estate planning mechanisms. In such situations, real estate owners may wish to sell their Like Kind Property and put the resulting proceeds into investments which can provide the kind of diversification, liquidity, divisibility, relative safety and steady income that many investors desire. Unfortunately, the sale of Like Kind Property may result in severe tax consequences for the investor, particularly when the investor is selling a highly appreciated property and/or a property with a very low tax basis.
Title 26, Section 1031 of the Internal Revenue Code (hereinafter “IRC Section 1031”) permits deferral of the taxes that would be due upon the sale of Like Kind Property by reinvesting the resulting proceeds into other Like Kind Property, subject to several conditions (“1031 Exchange”). The text of the IRC Section 1031 is reproduced herein:
Section 1031
Statute
(a) Nonrecognition of Gain or Loss from Exchanges Solely in Kind
                (1) In general        No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.        (2) Exception        This subsection shall not apply to any exchange of—                    (A) stock in trade or other property held primarily for sale,            (B) stocks, bonds, or notes,            (C) other securities or evidences of indebtedness or interest,            (D) interests in a partnership,            (E) certificates of trust or beneficial interests, or            (F) choses in action. For purposes of this section, an interest in a partnership which has in effect a valid election under section 761(a) to be excluded from the application of all of subchapter K shall be treated as an interest in each of the assets of such partnership and not as an interest in a partnership.                        (3) Requirement that property be identified and that exchange be completed not more than 180 days after transfer of exchanged property        For purposes of this subsection, any property received by the taxpayer shall be treated as property which is not like-kind property if—                    (A) such property is not identified as property to be received in the exchange on or before the day which is 45 days after the date on which the taxpayer transfers the property relinquished in the exchange, or            (B) such property is received after the earlier of—                            (i) the day which is 180 days after the date on which the taxpayer transfers the property relinquished in the exchange, or                (ii) the due date (determined with regard to extension) for the transferor's return of the tax imposed by this chapter for the taxable year in which the transfer of the relinquished property occurs.(b) Gain from Exchanges not Solely in Kind                                                
If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain, but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.
(c) Loss from Exchanges not Solely in Kind
If an exchange would be within the provisions of subsection (a), of section 1035(a), of section 1036(a), or of section 1037(a), if it were not for the fact that the property received in exchange consists not only of property permitted by such provisions to be received without the recognition of gain or loss but also of other property or money, then no loss from the exchange shall be recognized.
(d) Basis
If property was acquired on an exchange described in this section, section 1035(a), section 1036(a), or section 1037(a), then the basis shall be the same as that of the property exchanged, decreased in the amount of any money received by the taxpayer and increased in the amount of gain or decreased in the amount of loss to the taxpayer that was recognized on such exchange. If the property so acquired consisted in part of the type of property permitted by this section, section 1035(a), section 1036(a), or section 1037(a), to be received without the recognition of gain or loss, and in part of other property, the basis provided in this subsection shall be allocated between the properties (other than money) received, and for the purpose of the allocation there shall be assigned to such other property an amount equivalent to its fair market value at the date of the exchange. For purposes of this section, section 1035(a), and section 1036(a), where as part of the consideration to the taxpayer another party to the exchange assumed (as determined under section 357(d)) a liability of the taxpayer, such assumption shall be considered as money received by the taxpayer on the exchange.
(e) Exchanges of Livestock of Different Sexes
For purposes of this section, livestock of different sexes are not property of a like kind.
(f) Special Rules for Exchanges Between Related Persons
                (1) In general        If—                    (A) a taxpayer exchanges property with a related person,            (B) there is nonrecognition of gain or loss to the taxpayer under this section with respect to the exchange of such property (determined without regard to this subsection), and            (C) before the date 2 years after the date of the last transfer which was part of such exchange—                            (i) the related person disposes of such property, or                (ii) the taxpayer disposes of the property received in the exchange from the related person which was of like kind to the property transferred by the taxpayer, there shall be no nonrecognition of gain or loss under this section to the taxpayer with respect to such exchange; except that any gain or loss recognized by the taxpayer by reason of this subsection shall be taken into account as of the date on which the disposition referred to in subparagraph (C) occurs.                                                (2) Certain dispositions not taken into account        For purposes of paragraph (1)(C), there shall not be taken into account any disposition—                    (A) after the earlier of the death of the taxpayer or the death of the related person,            (B) in a compulsory or involuntary conversion (within the meaning of section 1033) if the exchange occurred before the threat or imminence of such conversion, or            (C) with respect to which it is established to the satisfaction of the Secretary that neither the exchange nor such disposition had as one of its principal purposes the avoidance of Federal income tax.                        (3) Related person        For purposes of this subsection, the term “related person” means any person bearing a relationship to the taxpayer described in section 267(b) or 707(b)(1).        (4) Treatment of certain transactions        This section shall not apply to any exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection.(g) Special Rule where Substantial Diminution of Risk        (1) In general        If paragraph (2) applies to any property for any period, the running of the period set forth in subsection (f)(1)(C) with respect to such property shall be suspended during such period.        (2) Property to which subsection applies        This paragraph shall apply to any property for any period during which the holder's risk of loss with respect to the property is substantially diminished by—                    (A) the holding of a put with respect to such property,            (B) the holding by another person of a right to acquire such property, or            (C) a short sale or any other transaction.(h) Special Rules for Foreign Real and Personal PropertyFor purposes of this section—                        (1) Real property        Real property located in the United States and real property located outside the United States are not property of a like kind.        (2) Personal property                    (A) In general            Personal property used predominantly within the United States and personal property used predominantly outside the United States are not property of a like kind.            (B) Predominant use            Except as provided in subparagraph 1 (C) and (D), the predominant use of any property shall be determined based on—                            (i) in the case of the property relinquished in the exchange, the 2-year period ending on the date of such relinquishment, and                (ii) in the case of the property acquired in the exchange, the 2-year period beginning on the date of such acquisition.                                    (C) Property held for less than 2 years            Except in the case of an exchange which is part of a transaction (or series of transactions) structured to avoid the purposes of this subsection—                            (i) only the periods the property was held by the person relinquishing the property (or any related person) shall be taken into account under subparagraph (B)(i), and                (ii) only the periods the property was held by the person acquiring the property (or any related person) shall be taken into account under subparagraph (B)(ii).                                    (D) Special rule for certain property            Property described in any subparagraph of section 168(g)(4) shall be treated as used predominantly in the United States.Footnotes                        
1. So in original. Probably should be “subparagraphs”.
(end of Section 1031)
Thus, for example, the owner of a small store could use a 1031 Exchange to defer taxes when he or she sells the store and reinvests the proceeds in, for example, an apartment building. To receive all of the benefits from an IRC Section 1031 Exchange, (i) the purchase price of the new property (“Replacement Property”) must be equal to or greater than the selling price of property sold (“Relinquished Property”), and (ii) to the extent the Relinquished Property was encumbered by debt, the investor must either utilize an equal or greater amount of debt to purchase the Replacement Property or contribute additional cash equal to or greater than such debt amount for the acquisition of the Replacement Property.
Thus, if the Relinquished Property was sold for $1,000,000, a Replacement Property must be purchased for at least $1,000,000. If the purchase price of the Replacement Property is less than the selling price of the Relinquished Property, taxes are payable on the difference, known as “boot”. On that same note, if the Relinquished Property was subject to $500,000 of debt at the time of its sale, a Replacement Property must be purchased using either $500,000 of debt or $500,000 of incremental cash contributed by the investor. If the combination of the debt amount and the additional cash contributed by the investor to acquire the Replacement Property is less than the debt of the Relinquished Property at the time of its sale, taxes are payable on the difference, known as “mortgage boot”.
IRC Section 1031 also imposes certain strict time limits for completion of a 1031 Exchange transaction. Once the Relinquished Property has changed ownership, the owner of the exchanged property (the “Exchanger”) has up to 45 days to identify Replacement Property, generally, for example, choosing either the three-property or the 200% rule, and a total of 180 days to close on the one or more of the identified Replacement Properties. If these strict time limits are not met, the transaction is not deemed to be a 1031 Exchange, and gains from the sale of the Relinquished Property are subject to taxation, which could be extremely costly to the Exchanger. Additionally, the Exchanger cannot exercise control, either direct or indirect, over the net proceeds resulting from the sale of the Relinquished Property. For this reason, the mechanics of an IRC Section 1031 Exchange generally are handled by a third party, a so-called “Qualified Intermediary,” who sells the Relinquished Property on behalf of the exchanger, holds the net proceeds resulting from such sale, acquires the Replacement Property that has been identified by the Exchanger within the allotted time frames, and subsequently transfers title to the Replacement Property to the Exchanger.
IRC Section 1031 Exchanges help mitigate the severe tax consequences of selling Like Kind Property by permitting a tax-deferred exchange of one piece of Like Kind Property for another. However, Section 1031 Exchanges alone may not provide investors with all of the benefits they desire. For most owners of investment real estate, particularly the majority of such owners who are not hands-on, active, professional real estate investors, it is difficult to identify, within the required 45 day period described above, one or more acceptable Replacement Properties satisfying the following generally desirable characteristics, among others: a) availability for purchase, b) reasonably priced, c) situated in a location convenient or desirable to the investor, d) sized appropriately so as to eliminate a “boot” problem, e) able to be leveraged so as to eliminate a “mortgage boot” problem, f) requiring less active management, g) featuring investment transparency such that the investor is aware of any faults early on in the 45-day identification period, and h) producing a current income stream and possessing other desirable investment parameters such as potential future liquidity, divisibility, and others discussed below. Also, because an IRC Section 1031 Exchange typically results in the ownership of a single Like Kind Property, other concerns of investors, such as diversification and divisibility are not addressed by IRC Section 1031 Exchanges. Furthermore, many attempted IRC Section 1031 Exchanges fail, with devastating tax consequences, due to difficulties in identifying and closing on suitable Replacement Properties within the strict time limits imposed by the statute. To frame the size of this problem, according to the Wall Street Journal, over $50 billion worth of 1031 Exchanges were completed in 1999 alone; therefore, a mere 10% increase in the success rate of completing 1031 Exchanges that year would have equated to more than $5 billion in additional 1031 Exchanges.
Some of the problems outlined above with respect to IRC Section 1031 Exchanges may be mitigated through the use of tenancy-in-common interests as Replacement Properties. Tenancy-in-common interests, which are simply undivided fractional co-ownership interests in Like Kind Property, are sold by a number of sponsors as Replacement Properties for investors seeking to complete IRC Section 1031 Exchanges. Some of the benefits of certain tenancy-in-common interests include a) their availability for purchase, b) the fact that they can often be sized appropriately so as to eliminate a “boot” problem, c) their need for less active management, and d) their ability in many cases to provide investors with a current income stream. Individual tenancy-in-common interests, however, also have their drawbacks, including some or all of the following: a) a lack of diversification to mitigate property, location, industry and tenant risks, b) a lack of liquidity, c) potential value dilution upon sale of the interest, d) undesirable governance provisions, d) a lack of divisibility, e) a lack of available non-recourse financing, f) a lack of flexibility in financing tailored to the specific needs of each exchanger, g) a lack of availability of attractive alternative properties due to supply/demand and timing constraints, h) very high upfront transaction costs resulting from market inefficiencies, i) unlimited liability of individual tenancy in common owners due to their classification under the law as not being limited partners or shareholders but rather as being co-venturers or general partners, and j) lack of full ongoing reporting transparency.
For example, it is difficult for an investor to diversify by obtaining tenancy-in-common interests in a number of different properties because (i) demand for such interests currently exceeds supply of attractive alternative properties, and (ii) sellers of tenancy-in-common interests have minimum investment thresholds per property, limiting the number of properties in which an investor can acquire interests given his or her available proceeds. Additionally, the full value of tenancy-in-common interests is often not realized unless the entire property, not just the tenancy-in-common interest, is sold. For this to happen in most cases, however, 100% of the tenancy-in-common owners of a particular property (which may number as high as 35) must unanimously agree to sell the property. While tenancy-in-common interests can be sold by themselves, this may be difficult to do and could result in the interests being sold for less than their underlying value, as up-front transaction costs and fees are typically very high and no secondary market has yet developed for such interests. Furthermore, many tenancy-in-common interest providers require investors to take on a high degree of leverage with respect to their interests (often more than such investors require to avoid mortgage boot), thus increasing the level of risk borne by such investors. Such providers also may require all investors to take the same blanket lien, thus hurting those investors desiring limited leverage. And finally, because of the current high level of demand for tenancy-in-common interests, providers of such interests are charging large up-front fees, sometimes approximating 25% of an investor's initial equity investment. Other further drawbacks to tenancies in common are discussed above, and include, for example, lack of divisibility and unlimited liability of individual tenancy owners.
One prior art approach for facilitating an IRC Section 1031 transaction is described in U.S. Pat. No. 6,292,788 B1 issued to Roberts et al. In Roberts, real property that may consist of a number of commercial real estate parcels and having a preselected total value is purchased and aggregated. The aggregated properties are then made the subject of at least one master agreement, and title to the property is then divided into tenant-in-common deeds, or deedshares, having pre-determined denominations. The deedshares are then used as Replacement Property under IRC Section 1031.
Although the creation of deedshares according to Roberts results in the formation of Replacement Property under IRC Section 1031, a Roberts transaction can have several disadvantages. For example, the master agreement must include restrictive provisions such that the tenancy-in-common is not viewed as a partnership under the tax laws, in order to maintain eligibility of the deedshares as Replacement Property under IRC Section 1031. As such, the terms of the master agreement typically prevent holders of deedshares from providing common services or entering into joint venture activities with respect to the aggregated properties.
Another drawback to a Roberts transaction is that because it is cumbersome to add/remove various properties to/from the properties under the master agreement, it is difficult to provide the deedshare holder with an interest in a diversified real estate portfolio over time. Further, although a Roberts transaction does provide limited additional diversification over single property alternatives, such level of diversification is far less than the degree of diversification that can be achieved via an Umbrella Partnership Real Estate Investment Trust. Additional exemplary drawbacks of the approach of Roberts are that deedshares are illiquid instruments which may experience value dilution upon sale, deedshare holders have unlimited liability with respect to claims against the tenancy-in-common, and deedshare holders are subject to the various undesirable governance provisions contained within most tenancy-in-common programs (as discussed above).
Numerous attempts have been made to provide small to mid-sized real estate investors with Like Kind Property that is diversified, liquid, enjoys favorable current income characteristics, requires minimal day-to-day management, features full reporting and information transparency, is readily divisible, shields investors from unlimited liability, and is not tied to unfavorable governance provisions. One way such investors can realize all of these benefits is by investing in a Real Estate Investment Trust, or REIT. A REIT is a company that typically operates a large pool of diversified, professionally managed, institutional quality real estate on behalf of its investors. Many REITs are publicly traded or, alternatively, publicly offer their securities, and are fully public reporting companies pursuant to SEC and/or Blue Sky regulations. Shares in a REIT may therefore be purchased, or (for REITs utilizing certain structures) acquired indirectly in exchange for real property, as described below. Because these shares are often publicly traded on major exchanges or come with full public reporting as described above, they have characteristics similar to the characteristics of shares in other “public” companies. For example, the shares are typically easy to liquidate, readily divisible, and often provide a reasonably favorable current income through regular dividend payments.
There are effectively two methods an owner of investment real estate can utilize to convert his or her investment into the equivalent of shares in a REIT. The first method is for the investor to simply sell his or her Like Kind Property and reinvest the proceeds in REIT shares. However, because REIT shares are not defined as Like Kind Property pursuant to IRC Section 1031 and an investor cannot therefore acquire REIT shares as Replacement Property under an IRC 1031 Exchange, this method may result in severe tax consequences for the investor, particularly if the investor is selling highly appreciated property and/or a property with a very low tax basis. The second method is for the investor to utilize a tax deferred exchange under Title 26, Section 721 of the Internal Revenue Code (hereinafter “IRC Section 721”) by contributing his or her Like Kind Property into a partnership in exchange for interests in the receiving partnership, typically using what is known as an Operating Partnership within an Umbrella Partnership Real Estate Investment Trust, or UPREIT, structure. The text of the IRC Section 721 is reproduced herein:
Section 721
Statute
(a) General Rule
No gain or loss shall be recognized to a partnership or to any of its partners in the case of a contribution of property to the partnership in exchange for an interest in the partnership.
(b) Special Rule
Subsection (a) shall not apply to gain realized on a transfer of property to a partnership which would be treated as an investment company (within the meaning of section 351) if the partnership were incorporated.
(c) Regulations Relating to Certain Transfers to Partnerships
The Secretary may provide by regulations that subsection (a) shall not apply to gain realized on the transfer of property to a partnership if such gain, when recognized, will be includible in the gross income of a person other than a United States person.
(d) Transfers of Intangibles
For regulatory authority to treat intangibles transferred to a partnership as sold, see section 367(d)(3).
(end of Section 721)
Pursuant to IRC Section 721, an investor can contribute property to a partnership on a tax-deferred basis in exchange for interests in the partnership. To utilize this provision of the tax code, many REITs have implemented the UPREIT structure. Under this structure, a REIT forms an affiliated Operating Partnership which serves as the entity that acquires and owns all of the REIT's real property, and the REIT acts as the general partner and typically the majority owner of the Operating Partnership, overseeing the Operating Partnership's activities. Interests in the Operating Partnership (“OP Units”) are the substantial economic equivalent of REIT shares, and the holders of OP Units are not liable for any debts, liabilities, contracts or obligations of the Operating Partnership in excess of their capital contributions to the Operating Partnership. In addition, holders of OP Units are typically allowed to exchange such units into shares of the affiliated REIT in full or in part at any time or from time to time. Further, holders of OP Units typically receive dividend distributions in the same amount and at the same time as dividends are paid to the REIT's shareholders. Therefore, OP Units, like REIT shares, typically represent a small piece of a large, diversified, professionally managed portfolio of institutional quality real property. While shareholders typically acquire their REIT shares for cash, and while the REIT typically acquires OP Units from its affiliated Operating Partnership using cash raised from such sale of its REIT shares, owners of investment real estate can acquire OP Units on a tax deferred basis by contributing their investment real estate to the Operating Partnership in exchange for OP Units pursuant to IRC Section 721.
The benefits to an investor of exchanging his or her investment real estate for OP Units are considerable. First, OP Units typically provide the investor with favorable current income in the form of regular dividend distributions that are derived from a diversified portfolio of real estate. Second, because the REIT handles the professional management of the portfolio of properties, the investor is freed from the burden of managing real estate investments. Third, as mentioned above, OP Units can be easily converted into REIT shares if the investor wishes to liquidate his or her investment. Fourth, the investor typically receives full reporting and information transparency as the REIT is typically a fully public reporting company. Fifth, as a limited partner, the investor is typically shielded from liability related to the operations of, and debt encumbering, the Operating Partnership's assets. Sixth, as mentioned above, the investor benefits from the diversification inherent in the REIT's portfolio, thus reducing property, location, tenant and industry risks. Also, OP Units are completely divisible, making them very effective tax and estate planning tools.
By way of background, in exchange for following a number of rules relating to the type of assets they can own, the type of income they can earn, and the amount of their income they are required to distribute to investors, REITs (unlike other corporations) pay no tax at the corporate level, effectively allowing them to pass along this substantial tax benefit and extra cash flow to their shareholders and OP Unit holders. One of these rules provides that REITs must distribute annually to their shareholders an amount equal to 90% of their pre-tax income. This effectively means that REITs typically pay high dividends relative to other corporations, which do not enjoy the REIT tax exemption at the corporate level, and which are not required to make any annual distributions. On the other hand, the 90% distribution requirement means that REITs cannot typically grow as a result of retaining their earnings as most of those earnings are currently required to be distributed annually. As a result, in order to grow, most REITs need to access the equity and debt markets on a regular basis to obtain new capital. As such, tax deferred contributions of investment real estate to an UPREIT in exchange for OP Units pursuant to IRC Section 721 provides a whole host of benefits to the REIT. First, because the REIT is acquiring properties directly for OP Units, the REIT is freed from the obligation, expense, and risk of first raising cash to acquire properties through the sale of REIT shares, and also from maintaining potentially dilutive sufficient cash reserves which might be necessary for taking advantage of future investment opportunities. Second, because investors can contribute their property to the UPREIT on a tax deferred basis, the REIT is able to acquire properties from investors that might not otherwise sell due to the potentially severe tax consequences of doing so, and may be able to acquire such properties at a more favorable price because investors are relieved of the obligation to pay tax on the sale of their property. As a result of the reasons mentioned above, UPREIT transactions typically provide REITs access to much needed capital on an efficient basis. Finally, the very act of seeking out investors looking to do tax deferred real estate exchanges puts REITs in touch with investors who may be interested in acquiring those properties the REIT wishes to permanently divest, as such properties could serve as the investors' Replacement Properties pursuant to their IRC Section 1031 Exchanges.
From the typical investor's perspective, however, there is one major drawback to the UPREIT structure: because the UPREIT will ultimately own the property it receives in exchange for the OP Units it provides to the investor, it must determine that the investor's property constitutes a desirable addition to its portfolio. Because the vast majority of the real estate owned by investors, and in particular small to mid-size investors, does not fit this description, most small to mid-size investors are unable to enjoy the substantial benefits afforded by the UPREIT structure.
In view of the foregoing, it would be desirable to provide to investors methods of investing in real estate that provide a degree of safety through diversification, a steady income stream, divisibility, ready liquidity, investment transparency, relatively low risk return, and limited involvement in management of property.
It would also be desirable to provide to investors methods and systems for exchanging investment real estate they currently own for investment real estate that possesses some or all of the characteristics outlined in the above paragraph, with the exchange being tax deferrable in accordance with IRC Section 1031 and/or IRC Section 721.
It would further be desirable to provide investors methods and systems for acquiring Replacement Properties in accordance with IRC Section 1031 that possess the characteristics outlined above, are readily available, are reasonably priced, can be easily identified within the 45 day time requirement, can be easily acquired within the 180 day time requirement, are sized appropriately so as to eliminate a “boot” problem, and are able to be leveraged, preferably on a non-recourse basis so as to eliminate a “mortgage boot” problem.
It still further would be desirable to provide REITs with the ability to efficiently raise capital and/or acquire properties from the very large number of small to mid-size owners of investment properties, regardless of what properties such investors currently own in terms of desirability to REITs.